Tuesday, December 16, 2008

Recession is time to leave high-yield bonds alone

Recession is time to leave high-yield bonds alone
Published: December 16 2008 02:00 Last updated: December 16 2008 02:00
Credit markets are in turmoil. The spread of investment-grade debt over US Treasuries is five times the 10-year average and at the widest level since 1933. As a result, investment-grade bonds may offer the opportunity of a lifetime. At the same time, emerging debt has never been as expensive in comparison.
The credit bubble has its roots in the monetary policy stance of the world's central banks immediately after the last US recession in 2001. Since then US interest rates have, on average, been held below the level of inflation. Such low real interest rates, at a time of economic prosperity, allowed enormous issuance of debt by countries and corporations, on terms that caused experienced credit investors to raise their eyebrows.
Such a loose monetary policy inevitably leads to problems and in recent months several countries have either defaulted or are on the brink of default. In 2006, Pakistan issued a 30-year bond at a spread over US Treasuries of just 300 basis points. That is a very low level for a country with such poor economic fundamentals and a history of political instability. While Pakistan has not yet defaulted, their bonds trade at about 40 cents on the dollar, suggesting that default is imminent. Other countries have defaulted, though. The Seychelles defaulted in August and over the weekend Rafael Correa, Ecuador's president, said his nation intended to default on its foreign debt.
Deleveraging on a massive scale has discouraged many investors from taking positions in credit markets, which in turn raises market volatility. With volatility comes an increased number of anomalies. For instance, over the past few years Russia (rated BBB) has been running large current account surpluses and paying down debt. In contrast, Turkey has been running large deficits and has substantially more government debt as a percentage of gross domestic product. However, 20-year Turkish dollar bonds yield a little over 8 per cent, whereas Russian sovereign debt yields more than 11 per cent.
But why own Russian sovereign bonds when there are higher-rated (single A) corporate bond issues yielding more than 12.5 per cent? In fact in our portfolio, we hold investment-grade debt with yields in excess of 25 per cent and lower-rated paper that yields in excess of 40 per cent. The point is credit risk is relative and there is no need to hold riskier credits yielding 8 per cent or even junk bonds yielding 22 per cent when you can achieve a similar, or even a higher, yield from investment-grade credits.
Emerging market debt spreads have yet to adjust fully to the realities of weaker global growth, falling commodity prices and higher defaults. Historically, emerging market debt has traded on similar spreads to high yield as both have similar underlying credit quality. However, currently spreads on high-yield are about 1,400bp wider than emerging market spreads.
In spite of the hype in recent years, many emerging market countries have weak economic fundamentals with several countries, including Ukraine, Hungary and Pakistan, needing to request support from the IMF. At current spreads investors are not being sufficiently compensated for the risks in many of these countries.
So where are credit spreads heading in the coming months? This recession will be the 11th since the second world war and, in all previous instances, credit spreads have ended the recession at wider levels than at the start. This suggests further pressure in the near term.
Our multifactor credit models, which have worked very well in recent times, also suggest wider spreads. The time to buy high-yield credit will not be until the recession has ended. Indeed, a simple strategy of buying high-grade and government bonds during recessions, and high-yield at other times, would have substantially outperformed all fixed-income sectors over the past 20 years.
Lastly, high-yield spreads are above 2,000bp and still widening. This provides a warning of how much emerging market spreads might widen, particularly the subinvestment-grade issuers. We think Turkey is very expensive and therefore vulnerable: and we all know what happens to Turkeys at Christmas.
The writer is co-manager of the Stratton Street Asian Bond Fund, a fixed income hedge fund.